Measuring Economic Performance
18 c h a p t e r
WHY DO WE MEASURE OUR ECONOMY’S PERFORMANCE?
There is a great desire to measure the success, or performance, of our national economy. Is it getting “bigger” (and, we hope better) or “smaller” (and worse) over time? Aside from intellectual curiosity, the need to evaluate the magnitude of the country’s economic performance is important to macroeconomic policymakers, who want to know how well the economy is performing so they can set goals and develop policy recommendations.
Measurement of the economy’s performance is also important to private businesses because inaccurate measurement can lead to bad decision making.
Traders in stocks and bonds are continually checking economic statistics—buying and selling in response to the latest economic data.
WHAT IS NATIONAL INCOME ACCOUNTING?
To fulfill the desire for a reliable method of measuring economic performance, national income accounting
was born early in the 20th century. The establishment of a uniform means of accounting for economic performance was such an important accomplishment that one of the first Nobel Prizes in economics was given to the late Simon Kuznets, a pioneer of national income accounting in the United States.
Several measures of aggregate national income and output have been developed, the most important of which is gross domestic product (GDP). We will examine GDP and other indicators of national economic performance in detail later in this chapter.
WHAT IS GROSS DOMESTIC PRODUCT?
The measure of aggregate economic performance that gets the most attention in the popular media is
gross domestic product (GDP), which is defined as the value of all final goods and services produced within a country during a given period. By convention, that period is almost always one year. But let’s examine the rest of this definition. What is meant by “final good or service” and “value”?
Measuring the Value of Goods and Services
Value is determined by the market prices at which goods and services sell. Underlying the calculations, then, are the various equilibrium prices and quantities for the multitude of goods and services produced.
What Is a Final Good or Service?
The word final means that the good is ready for its designated ultimate use. Many goods and services
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National Income Accounting: A Standardized Way to Measure Economic Performance
s e c t i o n
18.1
_ What reasons are there for measuring our economy’s performance?
_ What is gross domestic product?
_ What are the different methods of measuring GDP?
The paper used in this book is an intermediate good; it is the book, the final good, that is included in the GDP.
© Janis Christie/PhotoDisc/Getty One Images
are intermediate goods or services—that is, used in the production of other goods. For example, suppose United States Steel Corporation produces some steel that it sells to General Motors Corporation for use in making an automobile. If we counted the value of steel used in making the car as well as the full value of the finished auto in the GDP, we would be engaging in double counting— adding the value of the steel in twice, first in its raw form and second in its final form, the automobile.
MEASURING GROSS DOMESTIC PRODUCT
We can be calculate economic output using either of two methods: the expenditure approach or the income approach. Although these methods differ, their result, GDP, is the same, apart from minor “statistical discrepancies.” In the following two sections, we will examine each of these approaches.
THE EXPENDITURE APPROACH TO MEASURING GDP
One approach to measuring GDP is the expenditure approach. With this method, GDP is calculated by adding how much market participants spend on final goods and services over a specific period. For convenience and for analytical purposes, economists usually group spending into four categories: consumption, identified symbolically by the letter C; investment,
I; government purchases, G; and net exports, which equals exports (X) minus imports (M), or X 2 M. Following the expenditure method, then
GDP 5 C 1 I 1 G 1 (X 2 M)
CONSUMPTION (C )
Consumption refers to the purchase of consumer goods and services by households. For most of us, a large percentage of our income in a given year goes
The Expenditure Approach to Measuring GDP 385
1. We measure our economy’s status in order to see how its performance has changed over time.
These economic measurements are important to government officials, private businesses, and investors.
2. National income accounting, pioneered by Simon Kuznets, is a uniform means of measuring national economic performance.
3. Gross domestic product (GDP) is the value of all final goods and services produced within a country during a given time period.
4. Two different ways to measure GDP are the expenditure approach and the income approach.
1. Why does GDP measure only final goods and services produced, rather than all goods and services produced?
2. Why aren’t all of the expenditures on used goods in an economy included in current GDP?
3. Why do GDP statistics include real estate agents commissions from selling existing homes and used car dealers profits from selling used cars, but not the value of existing homes or used cars when they are sold?
4. Why are sales of previously existing inventories of hula hoops not included in the current year’s GDP?
s e c t i o n c h e c k
The Expenditure Approach to Measuring GDP
18.2
_ What are the four categories of purchases included in the expenditure approach?
_ What are durable and nondurable goods?
_ What are fixed investments?
_ What types of government purchases are included in the expenditure approach?
_ How are net exports calculated?
for consumer goods and services. The consumption category does not include purchases by business or government. As Exhibit 1 indicates, in 2003, U.S.
consumption expenditures totaled more than $7 trillion ($7,596 billion). This figure was 70 percent of GDP. In that respect, the 2003 data were fairly typical. In every year since 1929, when GDP accounts began to be calculated annually, consumption has been more than half of total expenditures on goods and services (even during World War II).
Consumption spending, in turn, is usually broken down into three subcategories: nondurable goods, durable consumer goods, and services.
What Are Nondurable and Durable Goods?
Nondurable goods include tangible consumer items that are typically consumed or used up in a relatively short period. Food and clothing are examples, as are such quickly consumable items as drugs, toys, magazines, soap, razor blades, light bulbs, and so on. Nearly everything purchased in a supermarket or drug store is a nondurable good.
Durable goods include longer-lived consumer goods, the most important single category of which is automobiles and other consumer vehicles. Appliances, stereos, and furniture are also included in the durable goods category. On occasion, it is difficult to decide whether a good is durable or nondurable; the definitions are, therefore, somewhat arbitrary.
The distinction between durables and nondurables is important because consumers’ buying behavior is somewhat different for each of these categories of goods. In boom periods, when GDP is rising rapidly, expenditures on durables often increase dramatically, while in years of stagnant or falling GDP, sales of durable goods often plummet.
By contrast, sales of nondurables like food tend to be more stable over time because purchases of such goods are more difficult to shift from one period to another. You can “make do” with your car for another year but not your lettuce.
What Are Services?
Services are intangible items of value, as opposed to physical goods. Education, healthcare, domestic housekeeping, professional football, legal help, automobile repair, haircuts, airplane transportation— all these are services. In recent years, U.S. service expenditures have been growing faster than spending on goods; the share of total consumption of services increased from 35 percent in 1950 to almost 60 percent by 2003. As incomes have risen, service industries such as health, education, financial, and recreation have grown dramatically.
INVESTMENT (I )
Investment, according to economists, refers to the creation of capital goods—inputs like machines and tools whose purpose is to produce other goods.
This definition of investment deviates from the popular use of that term. It is common for people to say that they invested in stocks, meaning they have traded money for pieces of paper, called stock certificates, that say they own shares in certain companies. Such transactions are not investments as defined by economists (i.e., increases in capital goods), even though they might provide the enterprises selling the stocks the resources to buy new capital goods, which would be counted as investment purchases by economists.
There are two categories of investment purchases measured in the expenditures approach: fixed investment and inventory investment.
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Amount (billions of Percent of Category current dollars) GDP
Gross domestic product $10,794 Consumption (C) 7,596 70% Investment (I ) 1,610 16 Government purchases (G) 2,090 19 Net exports of goods and services (X2M) 2502 25
SOURCE: U.S. Bureau of Economic Analysis, Survey of Current Business, September 2003.
2003 U.S. GDP by Type of Spending SECTION 18.2
EXHIBIT 1
Fixed Investment
Fixed investment includes all spending on capital goods—sometimes called producer goods—such as machinery, tools, and factory buildings. All these goods increase future production capabilities. Residential construction is also included as an investment expenditure in GDP calculations. The construction of a house allows for a valuable consumer service—shelter—to be provided and is thus considered an investment. Residential construction is the only part of investment tied directly to household expenditure decisions.
Inventory Investment
Inventory investment includes all purchases by businesses that add to their inventories—stocks of goods kept on hand by businesses to meet customer demands. Every business needs inventory and, other things equal, the greater the inventory, the greater the amount of goods and services that can be sold to a consumer in the future. Thus, inventories are considered a form of investment. For example, if a grocery store expands and increases the quantity and variety of goods on its shelves, future sales can rise. An increase in inventories, then, is presumed to increase the firm’s future sales, and this is why we say it is an investment.
How Stable Are Investment Expenditures?
In recent years, investment expenditures have generally been around 15 percent of gross domestic product. Investment spending is the most volatile category of GDP, however, and tends to fluctuate considerably with changing business conditions.
When the economy is booming, investment purchases tend to increase dramatically. In downturns, the reverse happens. In the first year of the Great Depression, investment purchases declined by 37 percent. In recent years, expenditures on capital goods have been a smaller proportion of GDP in the United States than they have in many other developed nations. This fact worries some people who are concerned about GDP growth in the United States compared to that in other countries, because investment in capital goods is directly tied to a nation’s future production capabilities.
GOVERNMENT PURCHASES IN GDP (G)
The portion of government purchases included in GDP is expenditures on goods and services. For example, a government must pay the salaries of its employees, and it must also make payments to the private firms with which it contracts to provide various goods and services, such as highway construction companies and weapons manufacturers. All these payments would be included in GDP. However,
transfer payments (such as social security, farm subsidies, and welfare) are not included in government purchases because that spending does not go to purchase newly produced goods or services but is merely a transfer of income among the country’s citizens (which is why such expenditures are called transfer payments). The government purchase proportion of GDP in the United States has grown rapidly over the last 30 years.
EXPORTS (X 2 M)
Some of the goods and services produced in the United States are exported for use in other countries.
The fact that these goods and services were made in the United States means that they should be included in a measure of U.S. production. Thus, we include the value of exports when calculating
The Expenditure Approach to Measuring GDP 387 Did you know that the estimate of vehicle miles traveled in 2000 was 2,688 trillion miles? The Federal Highway Administration is working with its partners in the state transportation departments to improve the larger National Highway System (NHS) of 160,000 miles. The Federal Aid Highway Program, begun in 1916, operates today with an annual budget of nearly $30 billion and is linked closely to the federal transit program.
© Eyewire/Getty One Images
GDP. At the same time, however, some of our expenditures in other categories (consumption and investment, in particular) were for foreign-produced goods and services. These imports must be excluded from GDP to obtain an accurate measure of U.S.
production. Thus, GDP calculations measure net exports, which equals total exports (X) minus total imports (M). Net exports are a small proportion of GDP and are often negative for the United States.
388 CHAPTER EIGHTEEN | Measuring Economic Performance
1. The expenditure approach to measuring GDP involves adding up the purchases of final goods and services by market participants.
2. Four categories of spending are used in the GDP calculation: consumption (C), investment (I ), government purchases (G), and net exports (X – M).
3. Consumption includes spending on nondurable consumer goods, tangible items that are usually consumed in a short period of time; durable consumer goods, longer-lived consumer goods; and services, intangible items of value that do not involve physical production.
4. Fixed investment includes all spending on capital goods, such as machinery, tools, and buildings. Inventory investment includes the net expenditures by businesses to increase their inventories.
5. Purchases of goods and services are the only part of government spending included in GDP. Transfer payments are not included in these calculations, because that spending is not a payment for a newly produced good or service.
6. Net exports are calculated by subtracting total imports from total exports.
1. What would happen to GDP if consumption purchases (C) and net exports (X2M) both rose, holding other things equal?
2. Why do you think economic forecasters focus so much on consumption purchases and their determinants?
3. Why are durable goods purchases more unstable than non-durable goods purchases?
4. Why does the investment component of GDP include purchases of new capital goods but not purchases of company stock?
5. If Mary received a welfare check this year, would that transfer payment be included in this years’ GDP? Why or why not?
6. Could inventory investment or net exports ever be negative?
The Income Approach to Measuring GDP
18.3
_ How is national income calculated?
_ What are factor payments?
_ What does personal income measure?
THE INCOME APPROACH TO MEASURING GDP
In the last section, we outlined the expenditure approach to GDP calculation. The alternative method, the income approach, involves summing the incomes received by producers of goods and services.
When someone makes an expenditure for a good or service, that spending creates income for someone else. For example, if you buy $10 in groceries at the local supermarket, your $10 in spending creates $10 in income for the grocery store owner. The owner, then, must buy more goods to stock her shelves as a consequence of your consumer purchases; in addition, she must pay her employees, her electricity bill, and so on. Consequently, much of the $10 spent by you will eventually end up in the hands of someone other than the grocer. The basic point, however, is that another person (or persons) receives the $10 you spent, and that receipt of funds is called income. Therefore, we can calculate the gross domestic product by adding all the incomes received by producers of goods and services because output creates income of equal value.
FACTOR PAYMENTS
Incomes received by people providing goods and services are actually payments to the owners of productive resources. These payments are sometimes called factor payments. Factor payments include wages for the use of labor services, rent for land, payments for the use of capital goods in the form of interest, and profits for entrepreneurs who put labor, land, and capital together. However, before we can measure income, we must make three adjustments to GDP. First, we must look at the net income of foreigners—the income earned abroad by U.S. firms or citizens minus the income earned by foreign firms or citizens in the United States. This difference between net income of foreigners and GDP is called gross national product (GNP). In the United States, the difference between GDP and GNP is small because net income of foreigners is a small percentage of GDP.
The second adjustment we make to find national income is to deduct depreciation from GNP.
Depreciation payments are annual allowances set aside for the replacement of worn-out plant and equipment. After we have subtracted depreciation, we have net national product (NNP).
The final adjustment is to subtract indirect business taxes. The best example of an indirect business tax is a sales tax. For example, a compact disc might cost $14.95 plus a tax of $1.20 for a total of $16.15.
The retail distributor (record store), record producer, and others will share $14.95 in proceeds, even though the actual equilibrium price is $16.15. In other words, the output (compact disc) is valued at $16.15, even though recipients only get $14.95 in income.
Besides sales taxes, other important indirect business taxes include excise taxes (e.g., taxes on cigarettes, automobiles, and liquor) and gasoline taxes.
Now we can measure national income (NI),
which is a measure of the income earned by owners of resources—factor payments. Accordingly, national income includes payments for labor services (wages, salaries, and fringe benefits), for use of land and buildings (rent), money lent to finance economic activity (interest), and payments for use of capital resources (profits). In Exhibit 1, the five primary categories of national income are presented with their proportions of national income: employee compensation, proprietor’s income (self-employed business owners), rents, interest income, and corporate profits.
In Exhibit 2, we see the circular flow of income and expenditures. People earn income from producing goods and services (aggregate income) and then spend on goods and services (aggregate expenditures),
C 1 I 1 G 1 (X 2 M). The main point is that buyers have sellers; that is, aggregate expenditures are equal to aggregate income.
PERSONAL INCOME AND DISPOSABLE PERSONAL INCOME
We should keep in mind that not all income can be used by those who earn it. Personal income (PI)
measures the amount of income received by households (including transfer payments) before income taxes. Disposable personal income is the personal income available to individuals after taxes.
The Income Approach to Measuring GDP 389
National Income, by Type of Income
SECTION 18.3
Amount (billions Percent of current dollars) of Total
National income $8637 Employee compensation 6112 71% Proprietor’s income 804 9 Rents 116 2 Interest income 700 8 Corporate profits 905 10
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Government Purchases ( G) Aggregate Expenditures Aggregate Income (Wages, Salaries, Rents, Interest, and Profits) Consumption (C)
_ _
Investment (I)
_
...
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